Here's what a Q3 2022 decline in venture capital investment means for entrepreneurs and investors

The narrative for the industry is changing as companies adopt a more defensive posture in response to market volatility.

In brief

• VC-backed companies raised $37 billion in Q3 2022, down 37% from Q2 2022.
• Despite the slowdown, significant dry powder is waiting to be deployed. VC funds raised $151 billion year to date, marking a record-setting year.
• To weather the looming economic storm, entrepreneurs should focus on execution, customer retention and unit economics.

Venture capital (VC) investment continued to weaken from the record-setting levels of 2021, declining by 37% in Q3 2022, from $60 billion in Q2 to $37 billion invested. Even with this significant drop-off, 2022 is already the second-highest investment year on record. In addition, we expect total investment to hit the $200 billion mark for the second year in a row and the fifth successive year of more than $100 billion in VC funding.

The narrative for the industry continues to change dramatically. Companies are now adopting a more defensive posture as entrepreneurs and investors are learning how to navigate through a vastly different landscape than what came before. Market volatility continues to persist due to inflationary pressures, rising interest rates and recessionary fears. At the same time, it’s important to remember that we’ve been through downturns like this before.

On the positive side, plenty of capital remains available on the sidelines. Entrepreneurs capable of putting together compelling business models will continue to raise money. Year to date, VC fundraising reached $151 billion, marking the fifth consecutive record year of fundraising.

With the fear of missing out that drove so much activity over the past year and a half gone, investors are now taking their time to deploy capital. Fundraising favors entrepreneurs who are executing, investing in customer growth and retention while demonstrating a path to profitability.

Mega-round financing

Mega-round count was off significantly quarter over quarter, continuing a nine-month slide as we return to pre-pandemic levels of activity. While all deal classes were down significantly, late-stage deals were down more than 50%, driven by a lack of mega-rounds. Mega-rounds have driven the strong growth in recent years, and this has contributed significantly to the reversal.

In Q3, health care led the way in mega-round financing, followed closely by energy. IT and business and financial services were significantly off by more than 80% and 60%, respectively. This is the first time in nearly a decade where energy cracked the top three sectors in mega-rounds.

Sectors

Energy and utilities have raised in nine months what they raised for all of 2021. The sector is riding a wave of interest in new technology that appears able to mitigate the climate crisis and combat the rising costs of commodities like oil and gas. Two of the top five deals were in this sector, led by a $1 billion investment in an electric vehicle charging infrastructure company. Other top energy deals include sustainable nuclear and clean energy and materials.

Information technology, typically the leading sector, is off 54% quarter over quarter. Software had its first sub $10 billion quarter since Q4 2020, which is significant given the strength this sector has shown in recent years.

Business and financial services and health care also posted significantly lower numbers, declining by 44% and 19% quarter over quarter, respectively.

Regions

The top four regions continue to be San Francisco, New York, Boston and Los Angeles, accounting for 63% of the investment in Q3.

Miami saw a rise in activity, ranking eighth by number of deals and sixth by amount of investment. As a new entrant to the top 10 in both categories, Miami is gaining steam as an emerging tech hub.

It may be too early to draw specific conclusions, but through a combination of technology enablement and talent mobility we believe that we will continue to see more hotbeds emerge.

What does this mean for entrepreneurs?

Entrepreneurs need to focus on execution, customers and demonstrating a path to profitability. In the current environment, it is critical to demonstrate near-term results with existing resources.

1. Put a heightened focus on customers. Given that it is less expensive to keep a customer than acquire a new one, reduce churn and focus on those who are more profitable. When delivering a product with high utility, negotiate up-front payments, if possible, with customers to fund additional investments or resources.
2. Critically challenge your product roadmap as it relates to timing and monetization. Can you get more from your customers today based on what you invested in your roadmap?
3. Make sure you have a proper support network in place to address the challenges and questions you will face in your professional life as well as your personal life.

Overall outlook

While some investors and entrepreneurs have experienced downturns in the past, many new entrants have yet to build up scar tissue, which will prove challenging.

October will offer a good proxy for what the new normal looks like. Slow activity over the summer will likely result in a softer start to the quarter because it takes time for new deals to get into the pipeline. We still predict full-year VC activity to finish above $200 billion for 2022.

We expect to see companies that offer real utility gain the most interest from investors, particularly those that develop products and services for necessities, such as energy, health care and information technology.

We are also seeing tremendous interest in climate-related technology, such as electronic vehicle charging and other green energy products. Investors are now more willing to focus on Clean Tech 2.0 as companies address climate change and develop differentiated energy sources.

I often remind investors and entrepreneurs that this current down period is only two minutes in a two-hour movie. The market will bounce back, and investors will continue to direct funding to companies with strong business models and compelling value propositions.

Source: Crunchbase as of October 3, 2022, Ernst & Young LLP

Disclaimer:

The views reflected in this article are the views of the author(s) and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization. Numbers included are from EY analysis and based on Crunchbase data unless noted otherwise. 

*We include equity financings into VC-backed companies headquartered in the US. Sources of cash investments include, but are not limited to, VC firms, corporate investors, other private equity firms and individuals.